10 value investing beliefs

Steve McCarthy

We consider it important to invest within a disciplined value investing framework in order to significantly outperform the market over the long term. Importantly, value investing can be applied to both high and low growth businesses; the key is to invest when the true underlying worth of the business is well above the current share price. In this wire, we share 10 of our value investing beliefs, together with some current interesting value-based, micro-cap opportunities with strong growth outlooks.

1. Knowledge and expertise are more important than diversification. We believe it is more important to know a small number of companies intimately than to know very little about a lot of companies. Risk can actually increase as you become more diversified and thus less knowledgeable about individual holdings.

2. The key valuation measure is future cash flow. The intrinsic value - the true underlying worth of the business - will vary over time as cash-flow certainty and the discount rate change. A strong track record of profit and cash flow growth, and good visibility around future growth provides confidence in our intrinsic values.

3. We reject the idea that risk is the standard deviation of historic returns, and believe that risk is the probabilistic assessment of something bad happening (i.e. the distribution has a single tail and is forward looking).

4. The share market can wildly mis-price companies relative to their intrinsic value but over time we believe shares prices will move towards fair value. In the short term, the share market is effectively a popularity contest, but over the long term share prices will reflect economic fundamentals. As a result, we are only focused on the long term.

5. “Mr Market” should be your friend. Bi-polar “Mr Market” provides prices every day – sometimes high and sometimes low. We believe investors should exploit his moods – buy when he is down and sell when he is high. You need to have a long term investment horizon which allows you to opportunistically profit from these mood swings.

"Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgement is sound, act on it- even though others may hesitate or differ. You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right. Similarly, in the world of securities, courage becomes the supreme virtue after adequate knowledge and a tested judgment are at hand.” ~ Benjamin Graham

6. We will only invest when we have a sufficient margin of safety. This means there should be a large gap between the intrinsic value and the current share price to allow for any inaccuracies in the assessment of the intrinsic value.

7. We believe management should be invested in their businesses to ensure their interests are aligned with shareholders, and that they treat other shareholders as partners.

8. Often family companies perform well because decisions are generally made with a longer time horizon and higher level of engagement in mind

9. Macroeconomic factors are very hard to forecast accurately and, given the long term nature of value investing, frequently of only limited relevance.

"The buyer of bargain issues places particular emphasis on the ability of the investment to withstand adverse developments.” Benjamin Graham

10. Investment opinions should be based upon a considered appraisal of a business/investment case against all known facts with the expectation that on average a superior return can be achieved. This contrasts with speculation which is short term and more akin to gambling.

“By speculating instead of investing you lower your own odds of building wealth and raise someone else’s” ~ Jason Zweig

Some micro-cap stocks that demonstrate these beliefs

A number of our portfolio holdings with growing operating businesses have the majority of their market caps supported by cash, liquid assets or other realizable assets.

Property fund manager and operator of the fast growing WOTSO co-working business, Blackwall (ASX:BWF), has a market cap of $55m with net tangible assets comprising property and investments in excess of $30m. WOTSO is growing revenues organically at c20% annually.

Diversified financial services provider, Euroz (ASX:EZL), has a market cap of $210m versus cash and other assets comprising $140m, whilst fund manager Elanor Investors (ASX:ENN) has a market cap of $180m versus investments totaling c.$160m. EZL has recently reported FY18 NPAT growth of 61%, while ENN has guided for a 27% increase in its earnings.

Sequioa Financial Group (ASX:SEQ) has a market cap of $35m and has recently announced a cash position of $16m - and a FY18 NPAT of $2.5m (FY17: $0.7m)

Having significant asset backing like these companies provides strong downside protection to our investment, while also meaning we are paying a low enterprise value for the growing operating business.

Investors can do well to focus on stocks with a long history of trading so they can effectively analyse and value the businesses, and obtain confidence in management's past behaviour and decision making. We do not invest in unprofitable and unproven start-ups, we only invest in well established businesses.

For example, Infrastructure services company SRG Limited (ASX: SRG) was founded in 1961 when it was contracted to install rock anchors for the Snowy Mountain Scheme. SRG listed on the ASX in 1987, which provides a significant amount of data to analyse and thus value the business across a variety of cycles. The origins of investment company Joyce Corporation (ASX:JYC) go back over 130 years, and it has been ASX listed since 1986.

We expect JYC and SRG to both deliver organic revenue growth of over 15% for FY18.

Focusing on stocks with undemanding valuations (low P/E stocks) gives a bigger margin of safety. Stocks such as Zenitas Healthcare (ASX:ZNT, community healthcare operator), Easton Investments (ASX:EAS, Accounting and wealth management services), and Traffic Technologies (ASX:TTI, supplier of smart city traffic management products and solutions) are all growing earnings with strong industry tailwinds behind them yet are trading on single-digit FY19 multiples. Investing in such low p/e stocks is a typical deep value investment strategy.

These examples above are just some of what we consider to be a number of value-based opportunities currently available in small, growing, profitable companies. They are well placed to deliver strong share price returns over the long term, and don't require heroic assumptions to support a meaningful intrinsic value.


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